What the heck is Quantitative Easing?

Doug Marshall, CCIM
Market Assessment

If you’ve listened to the news or read a newspaper in recent weeks there is a new buzz phrase being bandied about: Quantitative Easing. So what is it?

The term Quantitative Easing (QE) describes a form of monetary policy used by The Federal Reserve to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

The Federal Reserve does this by first crediting its own account with money it has created ex nihilo ("out of nothing") or some would say, by “printing money.” It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process referred to as open market operations.

The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy.

What is the purpose of Quantitative Easing?

The Federal Reserve has been given two mandates:

1. It is charged with ensuring full employment in the United States; and,

2. It is also charged with ensuring price stability. Inflation, in recent months, as measured by the CPI (Consumer Price Index), has declined to almost zero which is well below its target of two percent annually.

The Fed hopes that QE will stimulate the economy and thereby ease unemployment.

The Fed also hopes QE will bring the U.S. closer to its stated long-term inflation target.

The primary risk of QE is that it can spark inflation greater than desired or even hyperinflation. Or it could have no impact whatsoever.

Ben Bernanke, Chairman of the Federal Reserve, may be the “smartest guy in the room” but when he’s tweaking the largest economy in the world it is near impossible to really know what the impact The Fed policies will have on the economy.

What has been the impact of Quantitative Easing so far?

The first round of Quantitative Easing took place at the height of the financial crisis in late 2008 and early 2009. What impact did QE have on the economy and interest rates? Good question. I’m not sure anyone knows for sure.

Just recently the Federal Open Market Committee announced another round of Quantitative Easing called QE2. The Fed plans to purchase over $600 billion of long-dated Treasury securities over a period ending in June 2011.

Economists are debating what impact QE2 will have on interest rates. Ted Jones, PhD, Chief Economist for Stewart Title, says it has already significantly increased interest rates and uses the following table to support his position.

The table details the changes in constant-maturity Treasury rates since August 1, 2010. While rates are still comparably low, they have risen significantly in recent weeks.

As noted below in the table three-year Treasury yields are up 80 percent from the low just two weeks ago while two-year notes are up 60 percent. Even the 30-year Treasury yield has jumped 24+ percent since the end of August.

As convincing as this table is in supporting Dr. Jones’s opinion, I don’t think anyone can know for sure if the recent rise in interest rates can be directly attributed to the announced purchase of $600 billion of treasury securities over the next several months.

It seems to be too sharp of a rise in rates and it happened too quickly after The Fed announcement to be attributed to QE2.

But then again, who am I to disagree with such a distinguished and well qualified expert? We should know though in the next few months whether Dr. Jones is right or not. Let’s hope for all our sakes he’s not.

Sources:
Quantitative Easing by Wikipedia;
Does Quantitative Easing Work in Boosting the Real Ecomony? by Edward Harrison, November 4, 2010;
'Quantitative Easing': What Does It Really Mean for Investors?, Jeff Cox, CNBC.com, August 23, 2010;
Quantitative Easing Already Goosing Interest Rates, Ted Jones, Jones on Real Estate blog, November 14, 2010.

Why Interest Rates Will Rise

Doug Marshall, CCIM
Market Assessment

Shown below is an article written by Ted Jones, PhD who is the Senior Vice President-Chief Economist for Stewart Title Guaranty Company.

Mr. Jones opines about why interest rates will rise in the near term. He predicted back in August that rates would rise 100 basis point increase (1%) before the end of this year!


I wrote last month how a typical Japanese investor that had purchased a two-year Treasury note lost more than 10 percent per year on their investment – see post from September 27th – and that the only way they would keep coming back and buying U.S. Treasury instruments would be an increase (eventually) in interest rates.

Since then at the 17 economic forecast presentations I have given, the issue of rising rates seems to be most contemptuous by the audience. Simply stated, they believe that with no demand for money rates should not rise.

My response is that there is massive demand for money—but not in the typical avenues of home purchases, autos and other durable goods—and that is in record federal deficit financing and corresponding record-trade deficits.

Just look at the article link from the Wall Street Journal on Friday. The August trade deficit approached $50 billion ($46.3 billion to be exact) of which $28 billion was with China (and the $28 billion was an all-time record). Wow.

Add that to a massive Federal deficit in this past fiscal year of $1.3 trillion in 2010 and an a projection of $1.1 trillion in 2011 (that’s the off-budget surplus which reduces the deficit by estimated excess Social Security cash flows—with the 2011 on-budget deficit of $1.154 trillion) and you are looking at almost a couple of trillion of equivalent borrowing. Massive.

Looking at it another way, just contrast the Federal deficit of 2009 through 2011 to total commercial real estate lending in place and total first-lien residential loans in place.

Fannie Mae estimates that as of 2010 first-lien residential lending outstanding is $9.6 trillion and other sources tally total commercial real estate lending at $3.5 trillion. Total Federal deficits in 2009, 2010 and 2011 are estimated to be $1.4 trillion, $1.3 trillion and $1.1 trillion, respectively, for a total of $3.8 trillion.

That means that in just a 36 month period, the Federal government borrowed more money than all of the total commercial real estate loans outstanding. When comparing residential lending, that equates to 40 percent of the amount of the total first-lien lending outstanding on U.S. homes. Now you see that there is significant demand for borrowing.

Now throw in the inflation data contained in the linked Wall Street Journal article, and you might start being a believer in rising rates. Wholesale prices in the past three months jumped 1 percent (and yes—that includes energy and food, but unless you do not eat nor use any energy then that remains the appropriate factor) which annualizes to a potential 4 percent annual wholesale inflation rate.

The Fed released on Friday their expectations on inflation, but do not be surprised if they respond by stating they are going to increase the money supply by printing more money—which in the long run will be inflationary.

And that is my two cents. Or with inflation 2.08 cents……

I hope for all of our sakes that he is wrong about rising interest rates. What impact would a 1% rise in interest rates, over a short 3 month period, do to commercial real estate sales?

My guess is that everything would come to a stop until cap rates adjusted upward. And if you haven’t refinanced your properties, what are you waiting for?

Global Economic Issues Raise Their Ugly Head

Doug Marshall, CCIM
Market Assessment

I thought you would find the following article from Pacific Investment Management Company’s Chairman, Mohamed A. El-Erian interesting and informative.

This article was originally published on ftalphaville.ft.com on September 19, 2010. PIMCO is an investment company that manages the Total Return fund, the world’s largest mutual fund.

Shown below are Mr. El-Erian’s thoughts about two very important global economic issues.

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This coming week will be an interesting one. I am not just thinking of Tuesday’s FOMC meeting in Washington that will shed light on whether the Federal Reserve revises down its economic growth projections (it should and, I suspect, will) and expands non-conventional policies (it will, but probably not at this meeting).

I am also thinking of two other issues which were left to simmer quietly over the last few months when most of the focus was on America’s "recovery summer" — or, to be more exact, the lack thereof.

The first pertains to Europe. Solvency concerns are again on the rise there.

Last week’s catalyst was Ireland where banking issues are a serious worry. But the underlying problems are deeper and more complex.

Market measures of risk for peripheral European countries (Greece, Ireland, Portugal and Spain) are at or near danger levels… despite exceptional support from the European Central Bank, the European Union and the International Monetary Fund, and despite the implementation of adjustment measures on the part of some.

The failure to reduce risk spreads means that the public sector bailout is not working. Rather than provide assurances of better times ahead and, thus, encourage new investments, ECB/EU/IMF support funding is being used by existing investors to exit their exposures to the most vulnerable peripheral European countries.

This situation cannot be sustained forever. It undermines any chance that the most vulnerable countries (e.g., Greece) have of limiting the collapse in their GDP and maintaining social cohesion; it contaminates the balance sheet of the ECB; it exposes the revolving nature of IMF resources to considerable risk; and it raises the risk of renewed contagion.

The second issue is even more complex. It pertains to the global configuration of currencies.

Last week, Japan intervened massively to stop its currency from appreciating. It did so in a unilateral fashion and, immediately, faced criticisms from Europe and the U.S.

Meanwhile, in a sharply-worded testimony to Congress, Treasury Secretary Geithner provided lots of data to those that feel that the U.S should have already labeled China a currency manipulator.

And while China has recently accelerated the rate of its managed appreciation — 1% in the last week compared to just 1.6% since the country declared great "flexibility" back in June — this is proving insufficient to counter growing currency tensions.

These latest foreign exchange developments bring to the fore an inconvenient reality. While not all industrial countries wish to make it explicit, they are happy (indeed eager) to see their currencies depreciate.

They see this as helping them address the extremely difficult challenges associated with a protracted period of low growth, high unemployment, and limited policy effectiveness.

The list of industrial countries wishing to depreciate their currencies is not matched by a list of emerging economies happy to let their currencies appreciate significantly.

As a result, foreign exchange tensions are mounting, and the price of gold has been driven to a new record level.

This week will shed light on whether policymakers can do anything to deal with these two issues. If they continue to stumble and hesitate, what has been simmering may well come to a full boil in the next few months.

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You may ask, “Who cares about these global economic issues?” The reason to be concerned is that the global economy has a very real impact on the U.S. economy, for good or for ill.

The global community is now intertwined with each other in ways never before experienced. We’re all in it together.

Let’s hope that the power brokers, government bureaucrats and ivory tower economists know what they’re doing for the stakes are extremely high.

Banks On The Rebound

Doug Marshall, CCIM
Market Assessment


Second quarter banking results show strong evidence that U.S. banks are beginning to dig themselves out of the big hole they’ve been wallowing in for the past three years.

Among some of the rosier statistics are:

• The FDIC second quarter numbers showing 90-plus day delinquencies leveling off and eventually set to decline because 30-89 day delinquencies are declining. Also, net charge-offs are leveling off too.
• The banking industry’s quarterly earnings of $21.6 billion are up dramatically from a year ago loss of -$4.4 billion and represent the highest quarterly earnings since the third quarter 2007.
• Sixty-five percent of the banks are reporting higher year-over-year quarterly net income.
• Loan loss reserves are showing improvement as insured institutions added $40.3 billion in provisions to their loan loss allowances in the second quarter. While still high by historic standards, this is the smallest total since the industry set aside $37.2 billion in the first quarter of 2008.

“Without question, the industry still faces challenges. Earnings remain low by historical standards, and the number of unprofitable institutions, problem banks and failures remains high,” says FDIC chairman Sheila C Bair.

“But the banking sector is gaining strength. Earnings have grown, and most asset quality indicators are moving in the right direction.”

Regionally, Sterling Savings Bank has been successful in raising the required funds to stay in business while Bank of the Cascades has asked for another extension.

Having both of these banks come back from their death beds would be encouraging to a Pacific Northwest economy that has been slow to recover.

From our perspective at Marshall Commercial Funding, we are witnessing a number of lenders coming back into the market in the last few months, some with very favorable rates and terms.

It’s too soon to say the banking crisis is over but it is encouraging to see the baby steps being taken in the right direction.

Sources:
U.S. Banks Report CRE Loan Troubles Subsiding Amid Strong Quarterly Earnings, CoStar Group, September 8, 2010;
Sterling Financial hits $730M investment goal, Portland Business Journal, August 28, 2010;
Bank of the Cascades gets another extension, Portland Business Journal, July 16, 2010.

The Apartment Market is on the Mend!

Doug Marshall, CCIM
Market Assessment

Whether you read the Norris & Stevens most recent Apartment Investors Journal or listen to CoStar’s recent webinar overview on the U.S. apartment market or read Portland State University’s Real Estate Quarterly for August, all are in agreement – THE APARTMENT MARKET IS ON THE MEND!

The apartment market bottomed out in the last half of 2009 and several factors indicate that it has turned a corner, such as:

• Vacancy rates have dropped
• Concessions are being reduced
• Effective rent growth has turned positive
• Demand for apartments is up
• Supply of new rental product is down
• Cap rates are being compressed

Vacancy rates have dropped – according to the Metropolitan Multifamily Housing Association the apartment vacancy rate for the Portland metro area is currently 5.1%, down from 5.9% in the fall of 2009.

Nationally, CoStar is reporting a decline in apartment vacancy from 8.4% last year to about 8.0% at the end of the second quarter of 2010.

Concessions are being reduced – concessions are more difficult to track but generally it is believed, and anectdotal evidence suggests, that there are fewer concessions being offered and for smaller amounts than last year at this time.

Effective rent growth has turned positive – according to Norris & Stevens, older apartments have increased rents 0.8% and newer units increased 2.34% from 2009 to 2010.

CoStar is reporting positive effective rent growth of about 0.7% for Class A & B properties in the first half of 2010, the first time since the fourth quarter of 2008; effective rent growth for Class C properties is almost at breakeven.

Demand for apartments is up – Norris & Stevens report cites a Barron’s article which projects a decrease in home ownership from the current 67.2% of all households to 64% by 2015.

Apartments will gain a stronger market share as many families lose their homes to foreclosure. Stricter lending guidelines for home loans will continue this trend. For every 1% drop in home ownership results in 1.4 million new rental households.

Supply of new rental product is down – according to PSU’s Real Estate Quarterly Summer edition new apartment construction has experienced a strong drop off in 2009 and for the first half of 2010.

Historically, Portland has averaged almost 2,000 permits for multi-family units annually. Last year Portland issued 235 multi-family permits and through June of this year only 164 units. Washington, Multnomah & Clackamas counties have experienced similar declines.

Cap rates are compressing – CoStar reports that cap rates have declined from 7.0% to 6.4% in the past 6 months.

However, there are too few sales in the Portland market to show a trend. Norris & Stevens reports cap rate averages by county ranging from a low of 6.5% to a high of 8.73%.

This all bodes well for the apartment investor. The big question is when will the other property types follow along?